Imagine a scenario where you want money. What do you do? First, we ask our closest circle: parents, spouse, relatives and friends. Of course, they will support to their best of abilities. What if, you want more? You approach a bank or any financial institutions to borrow money. If you still want more money, you will probably part away with something you own (equity) in return for money.
Now imagine that you own a very big company. You will be willing to part of your ownership in return for money, which you can use either to pay yourself or to reinvest in your company to grow it even further. So, where does shares come in all this? What does it mean in relation to a company? Well, as its literal meaning, a share (or a stock) is a percentage of ownership. The company founder / leader, has made available a part of company available for public to generate money.
Therefore, when you buy the shares of a Company Z, you’re practically buying a percentage of ownership of the Company Z. When you own a part of a company, you are entitled to a share its profits through dividend. However, not all companies share their profits with their shareholders. Some reinvest it either as upgrades to the existing value chain, or as a bonus to employees or in some other instrument. They could just save it in bank as “Cash” for future usage.
Now then, how does one make the wider audience know that the equity shares are available for purchase. For a large well-known company this is not a problem, but for smaller up and coming companies, it would be very difficult to do this. That’s where the stock exchange comes in. A common platform is set up where all buyers and sellers of shares converge to trade. Since its bid / sale model, the demand and supply automatically decides the price of the share and by extension the value of the company
Listing equity through IPO
When the company is interested to sell their shares, they confer with all owners and get their consensus. Once the approvals are in place, they hire one of the underwriters like KPMG, LIC etc. to represent their interest in the market. Internal due diligence of the company happens and company finally submits “Red Herring” prospectus with all documents like their financial performance, company profile, corporate governance etc. to stock exchange with a guarantee that all information submitted are accurate.
After approval the company releases the prospectus, inviting bids from interested parties, which contains the details relating to the company, its past performance, the issue price, how the company is going to use the proceeds from sale and its outlook. Then the public bids on the equity ownership of the company regulated by stock exchange. This whole process is “Initial Public Offering” or IPO.
Market Capitalization of a company
After this offering, shares (equity) list in the open market at initial price. Then, market effect comes into play and price changes in relation to the supply & demand. The price defines the company’s size referred as market capitalization. It is a product of total no. of outstanding shares and its corresponding price. Based on the market capitalization, the companies categorize as Small cap, medium cap and large cap.
Now, you may wonder how the market price of the shares really help a company. In reality, the main use of the market price of the share for the company is to generate cash and working capital for the company. Higher the price, more money you can generate by either pledging as a collateral or selling it. It is like owning a land.
In normal parlance, it is like owing a piece of land in prime developing location. The value of the land may appreciate and make you a millionaire by net worth, but unless you actually sell / pledge the land, it is nothing but paper money. Of course, you can always flaunt it in front of everyone, but you still have to work to generate income for sustenance.